Solvency means the company’s ability to make its agreed payments over the long term . Information on a company’s solvency is of great interest to those financial institutions approached by the company for finance .
These institutions must immediately analyse the company’s situation in order to assess the risk that the company will be unable to make its agreed payments.
A company’s solvency also implies its ability to survive and remain viable in the long term, which is an important consideration for all interested parties.
To carry out an analysis based on cash flow, we will firstly consider what part of the long-term liabilities is covered by liquidity reserves. For this we use the following ratio:
If this is less than the unit , the reserves are insufficient to cover the liabilities; we then compare those liabilities not directly covered with the cash flow. In this case, the value of the ratio indicates what portion of the liabilities can be paid off with net annual cash flow, and it will also tell us the period of expected repayment
It is also advisable to study the components of the net operating cash flow in depth to determine at what level it might stand in the future , so it is necessary to calculate three coverage ratios :
This indicates whether operating expenses can be covered by operating income. This ratio is expected to show values that are above the unit . If the ratio is close to the unit, it means there is a strong probability that the company will incur a negative EBITDA.
This measures how much is needed to cover debt interests by taking into account gross operating cash flow or EBITDA as a resource. This ratio is also expected to be well above the unit as a reference value
This is the assessment of how taxes can be paid, again taking into account the EBITDA as a resource for this, with the financial costs discounted. Ideally the highest value above one should be used .As with other coverage ratios , it is advisable to compare against the sector values available as well as examining its temporary evolution
This measures the relationship between total share value and the debts that make up external capital (non-current liability plus current liability). If the ratio is greater than the unit , it indicates that the company, in a state of liquidation, could pay off the external capital it has been financed with.
It is the opposite of the previous one. It is interpreted as a measure of the debt taken on by the company to finance its assets
Debt ratio = Liabilities
This ratio usually moves between 0.4 and 0.6, and its value must be compared to sector references. The total of liabilities is the same as external liability, that is, the total of current and non-current liability.
Debt to equity ratio
This ratio, which is another version of the previous one, is used as an instrumental variable in the analysis of financial leverage described in Chapter 9.
Sometimes the company is exposed to risks (robbery, fire, flooding and other contingencies), not covered by insurance or by accounting provisions, that can impact on the solvency.
If the financial statements were audited, the auditors would have assessed these risks
If there were not audited, the analyst would have to check these factors
The risks pertaining to other names are those risks that the company incurs when endorsing operations undertaken by other persons or entities. Thus, the debts that might arise if the endorsed party fails , must be taken into consideration